“To contract new debts is not the way to pay old ones.”
  —George Washington

Ballooning Government Debt

The chart below boggles the mind as it shows the rapid acceleration of the United States national debt. In 2000 the national debt was less than half of what it is today. And stunningly, the U.S. has accumulated more debt over the past ten years than it had over the prior century.¹

On December 24, 2009 the debt ceiling was raised to $12.394 trillion via H.R. 4314.² An additional increase in the U.S. debt limit to $14.3 trillion was signed into law by President Barack Obama on February 12, 2010.³ One thing we’ve noticed, is that Congress seems to have never met a debt ceiling it did not like to max out. And we’d not be surprised to see the new $14.3 trillion limit hit relatively soon as the pace of the debt increase seems to be reaching “warp drive.”

As an aside, we think it’s important to also point out that via the Housing and Economic Recovery Act of 2008 and the 2008 Federal Housing Finance Agency Conservatorship – the U.S. Government has more explicitly backed Fannie Mae and Freddie Mac. The combined obligations of these two independent GSEs is over $5 trillion.⁴ The Congressional Budget Office has recommended adding the assets and liabilities of Fannie and Freddie to the federal budget because of the amount of government control and involvement with them.⁵ Ignoring this recommendation, the government still accounts for these corporations as if they are unconnected to its balance sheet – even though the taxpayers are once again on the hook.

The Real Question Is…

Our clients know it’s long been our view this cannot continue forever. We’re seriously concerned the debt of the U.S. and other developed nations will grow so big they’ll have no alternative but to print money in attempt to keep the party going. In our opinion, talk of raising interest rates to defend the currency is just that – talk. We believe higher interest rates would tank an already cheap-credit addicted economy. And we’ve noticed throughout history – governments (when their currencies are not backed by gold – and today, none in the world are) – tend to repudiate their debt by inflating/printing it away.

To us, the real question is – as the government continues watering down the value of the Dollar it must pay its ballooning debts back with – what are you doing to help make sure the purchasing power of your hard-earned Dollars is not eroded away in the process?

While there is a lot of tough reality going on out there — we maintain our positive outlook. That outlook is based on our belief that a bear market in one thing is often a bull market in another.

As we enter this critical time – now, more than ever – we believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.

Sincerely,

Stephan R. Ernharth, JD, AIFA
Vice President
Ernharth Group

“Our whole Depression was brought on by gambling, not in the stock market alone but in expanding and borrowing and going in debt, all just to make some money quick.“
—Will Rogers, May 5, 1935

Hot and heavy is the current debate (and rhetoric) over the need for increased regulation of the financial industry. Some believe it’s absolutely required, while those in the opposing camp feel it’s simply political posturing and demagoguery. Will limiting bonuses do the trick? Or do such measures really miss the root of the problem?

Now re-appearing in the debate is a review of the repeal in 1999 of a crucial segment of legislation created in a bygone era to protect against certain consequence-laden shenanigans of finance.

Included in the Glass-Steagall Act of 1933 were provisions prohibiting a bank holding company from owning other financial companies – thus separating commercial and investment banking to protect depositors from the dangers of risky investments and speculation. According to the New York Times, Glass-Steagall was:

“…enacted as an emergency response to the failure of nearly 5,000 banks during the Great Depression… Beginning in the 1900s, commercial banks established security affiliates that floated bond issues and underwrote corporate stock issues… The expansion of commercial banks into securities underwriting was substantial until the 1929 stock market crash and the subsequent Depression. In 1930, the Bank of the United States failed, reportedly because of activities of its security affiliates that created artificial conditions in the market. In 1933, all of the banks throughout the country were closed for a four-day period, and 4,000 banks closed permanently…

In order to restore the banking public’s confidence that banks would follow reasonable banking practices, Congress created the Glass-Steagall Act… preventing commercial banks from underwriting securities… Likewise, investment banks may not engage in the business of receiving deposits.”¹

In 1999, the interestingly named “Financial Services Modernization Act” (Gramm-Leach– Bilely) repealed Glass-Steagall’s prohibitions – permitting securities firms, banks, and insurance companies to affiliate.² The Senate passed the Act 90–8³. Only one Republican voted against it (Alabama’s Richard Shelby) – while seven Democrats opposed the measure.⁴ Democrat Senator Byron Dorgan stated, “I want to sound a warning call today about this legislation… I think this legislation is just fundamentally terrible.“⁵ Boston College finance professor Edward Kane warned “Nobody will be able to discipline a Citigroup.“⁶ Ralph Nader bluntly opined at the time, “We will look back at this and wonder how the country was so asleep… It’s just a nightmare.“⁷ They were not alone. In our opinion, it looks like time has proved them right.

On the other hand, then-Treasury Secretary and current Director of the White House’s National Economic Council for President Obama, Lawrence Summers, exulted, “Today Congress voted to update the rules that have governed financial services since the Great Depression and replace them with a system for the 21st century.”

Quite an “update” indeed.

Thus, one wonders whether President Obama’s recent proposals to impose restrictions on financial firms will actually have teeth. Using history as a guide – we think some old– fashioned “Glass-Steagall” might do some good.

As we enter this critical time — now, more than ever — we believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.

Sincerely,

Stephan R. Ernharth, JD, AIFA
Vice President
Ernharth Group

Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passion, they cannot alter the state of facts and evidence.“
—John Adams

A More Detailed and Realistic Look at Unemployment

We’ve long been skeptics of “official” government figures. And we leave it to John Williams at Shadow Government Statistics to paint a more detailed and accurate picture of the U.S. unemployment rate. As believers in the maxim “pictures paint a thousand words” – to us, the Shadow Government Statistics Chart below is an eye-opener.

Per Williams’ site the unemployment stats in the chart are explained as follows:

“The U-3 unemployment rate is the official monthly headline number.“¹

“The U-6 unemployment rate is the Bureau of Labor Statistics’ (BLS) broadest unemployment measure, including short-term discouraged and other marginally-attached workers as well as those forced to work part-time because they cannot find full-time employment.“²

“The seasonally-adjusted SGS Alternate Unemployment Rate reflects current unemployment reporting methodology adjusted for SGS-estimated long-term discouraged workers, who were defined out of official existence in 1994 (our emphasis). That estimate is added to the BLS estimate of U-6 unemployment, which includes short-term discouraged workers.“³

In other words, the chart indicates the “real” unemployment rate is far higher than the headline 10% rate. When short-term discouraged and marginally-attached workers, those forced to work part-time because they cannot find full time employment, and long-term discouraged workers are added together – the U.S. unemployment rate hovers around 22%.⁴

A Sobering Assessment

In our January 8th commentary “Man of the Year” – we included a chart showing that we now may be in the “eye” of what could turn out to be a mortgage re-set hurricane.

In his January 10, 2010 commentary at www.telegraph.co.uk titled, “America slides deeper into depression as Wall Street revels” – Ambrose Evans-Pritchard writes:

“The labour force contracted by 661,000. This did not show up in the headline jobless rate because so many Americans dropped out of the system. The broad U6 category of unemployment rose to 17.3pc. That is the one that matters. Wall Street rallied. Bulls hope that weak jobs data will postpone monetary tightening: a silver lining in every catastrophe, or perhaps a further exhibit of market infantilism.

The home foreclosure guillotine usually drops a year or so after people lose their job, and exhaust their savings… Realtytrac says defaults and repossessions have been running at over 300,000 a month since February. One million American families lost their homes in the fourth quarter. Moody’s Economy.com expects another 2.4m homes to go this year. Taken together, this looks awfully like Steinbeck’s Grapes of Wrath… The home seizures are occurring despite frantic efforts by the Obama administration to delay the process… This policy is entirely justified given the scale of the social crisis. But it also masks the continued rot in the housing market, allows lenders to hide losses, and stores up an ever larger overhang of unsold properties. It takes heroic naivety to think the US housing market has turned the corner (apologies to Goldman Sachs, as always).

The fuse has yet to detonate on the next mortgage bomb, $134bn (£83bn) of “option ARM” contracts due to reset violently upwards this year and next. US house prices have eked out five months of gains on the Case-Shiller index, but momentum stalled in October in half the cities even before the latest surge of 40 basis points in mortgage rates. Karl Case (of the index) says prices may sink another 15pc. “If the 2008 and 2009 loans go bad, then we’re back where we were before – in a nightmare.” David Rosenberg from Gluskin Sheff said it is remarkable how little traction has been achieved by zero rates and the greatest fiscal blitz of all time. The US economy grew at a 2.2pc rate in the third quarter (entirely due to Obama stimulus). This compares to an average of 7.3pc in the first quarter of every recovery since the Second World War… For the record, manufacturing capacity use at 67.2pc, and “auto-buying intentions” are the lowest ever.

The Fed’s own Monetary Multiplier crashed to an all-time low of 0.809 in mid-December. Commercial paper has shrunk by $280bn ($175bn) since October. Bank credit has been racing down a hair-raising black run since June. It has dropped from $10.844 trillion to $9.013 trillion since November 25. The MZM money supply is contracting at a 3pc annual rate. Broad M3 money is contracting at over 5pc.

The stock market has become a lagging indicator. Tear up the textbooks.”⁵

Sobering words indeed. And while Mr. Pritchard’s commentary reflects his personal opinions – it’s also loaded with cold, hard, facts which, as unpleasant as they may be – are difficult for us to deny. And we’re in the fact business. Rather than denial – we’ve chosen to embrace the facts – because after all, they’re what reality is based on. And only in reality lies opportunity.

As we enter this critical time — now, more than ever — we believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.

Sincerely,

Stephan R. Ernharth, JD, AIFA
Vice President
Ernharth Group

Mortage Redux

We like to kid – and as always, we remain positive in our outlook on potential opportunities. That said, what else is a $12 trillion national debt other than a massive hole? And, ah “Helicopter Ben.” This year he may once again be forced to man the choppers to dump more newly printed money in another attempt to save the economy and financial system. We think the odds he’ll do so are increasing. After all, Congress again raised the government debt ceiling on Christmas Eve by $290 billion – to $12.4 trillion.¹ The increase was requited to avoid a default on U.S. Government debt and promises – and to deal with the record $1.4 trillion deficit it had accumulated in 2009.² What concerns us is in recent years is we’ve never seen a debt ceiling Congress has not wanted to max out. Yes, Republicans criticized the latest legislation – yet under the recent Bush administration they regularly voted for 8 debt ceiling increases adding up to $5.4 trillion.³ The recent increase allows the government to issue enough bonds to fund itself through mid-February – and Congress will again address the subject on January 20th.⁴ Democrats had originally desired to pass an unparalleled increase of nearly $2 trillion but the plan lost momentum as moderate Senate Democrats opposed it.⁵ We’d not be surprised to see another increase – and soon.

And as nice as it would be to have the worst of the mortgage crisis behind us – that may not be the case. The chart below shows us as we now may be in the “eye” of what could turn out to be a mortgage re-set hurricane. The vast majority of sub-prime mortgage re-sets (of interest rates) – peaked in 2007/2008. However, as we enter 2010 more large-scale re-sets loom – with Option-Arm mortgages leading the way – gaining momentum throughout the year and forecast to peak in 2011/2012.

What concerns us is the possibility that as mortgage re-sets again accelerate – so too may foreclosures if homeowners cannot keep up with increased payments. This could be exacerbated if the unemployment situation does not improve – or worse yet accelerates. As we can see from the following chart – the foreclosure rates have trended up rather steadily over the past 4 years. What will be the total effect of the lax lending standards on loans made through 2007? We shall soon see.

Man of the Year

We’ve long felt that the Austrian School of economics espouses the most common sense thought. Primarily, that a currency must be backed by gold to maintain its integrity (and to protect the savings of citizens); markets – not central banks or the government should determine interest rates; going further into debt does not cure debt nor does it create a healthier economy; and that printing money does not equal prosperity. Ben Bernanke, a Kensyian – disagrees. While we’re concerned his efforts will just make the situation worse – we don’t think he’d listen to us at all. We believe he will print – and print. And we think the next few years will be quite telling for him. He was voted Time Magazine’s Man of the Year for 2009 – and kudos to him. Former winners on the list include Gandhi, Martin Luther King Jr., and Pope John Paul II. Also on the list are Hitler, Stalin (a double winner), and Khrushchev. For posterity’s sake (and all of our sakes) – we wish him luck.

And while we don’t agree with his policies – we believe they provide opportunities. As always, that’s what we’re focusing on.

Sincerely,

Stephan R. Ernharth, JD, AIFA
Vice President
Ernharth Group

“The power to determine the quantity of money… is too important, too pervasive, to be exercised by a few people, however public-spirited, if there is any feasible alternative. There is no need for such arbitrary power… Any system which gives so much power and so much discretion to a few men, [so] that mistakes — excusable or not — can have such far-reaching effects, is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic — this is the key political argument against an independent central bank.”

—Milton Friedman

Keeping the Pedal to the Metal

As we’ve listened this year to past comments on the Federal Reserve Bank’s plans to withdraw stimulus at some point in time — we can’t help but remain skeptical. It’s been our long-standing belief despite its strong-Dollar tough talk — the Fed will keep rates low out of its fear that to do otherwise would cause the credit dependent economy to tank. After decades of easy monetary policy it would seem natural to us for asset prices to experience a large-scale regression to the mean. In other words — what goes up, typically must come down. In our opinion, without Fed stimulus the money and credit supply would likely contract — and asset prices would drop. If that occurred, savers would be rewarded as their cash gained in purchasing power. However, debtors would be punished as the value/cost of their outstanding debt (to be paid back in stronger dollars) would be higher. And there lies the rub. Paying its debt back in more valuable Dollars gaining in purchasing power would be quite painful to a massively indebted U.S. government. And that’s why we maintain our belief the U.S. will continue to employ the printing press to water down the Dollar it must pay its $trillions of unfunded liabilities and debts back with.

On November 18th James Bullard, President of the Federal Reserve Bank of St. Louis stated that interest rates may be held low until early 2012.¹ That, along with Fed Chairman Ben Bernanke’s recent statements that “significant economic challenges remain“²… “Jobs are likely to remain scarce for some time, keeping households cautious about spending“³… and the job market is an “area of great concern“⁴ — strengthens our belief the money printing pedal will remain firmly planted to the metal.

Global Response

As a result, President Obama is catching heat from the leaders of Asian countries — many of which peg their currency to the Dollar in some way.⁵ These nations are benefitting from the Dollar carry trade — where investors borrow greenbacks at low-interest rates and invest them in foreign markets seeking higher returns.⁶ This has resulted in Asian stock markets substantially outperforming those in the U.S. and Europe.⁷ However, these same nations are growing increasingly concerned over asset bubbles created by easy money. On November 13th, Donald Tsang, Hong Kong’s Chief Executive stated about U.S. money printing:

“Where is the money going—it’s where the problem’s going to be: Asia… You can see asset prices going up, not only in Korea, in Taiwan, in Singapore, and in Hong Kong, going up to levels that are incompatible or inconsistent with the economic fundamentals.“⁸

President Obama response was to call for “balanced trade” which may be interpreted as continued support for a weaker Dollar.⁹

And we believe European Central Bank President Jean-Claude Trichet was being diplomatic when he said on November 17th:

“I believe that the strength of the dollar within the set of floating currencies is in the interest not only of the United States, but of the entire international community.“¹⁰

Mr. Trichet sounds like a man with not much leverage.

On the Other Hand

While the U.S. is certainly printing a lot of money — China, in our eyes, is also responsible for global monetary inflation which may lead to substantial economic problems in the future. By pegging the Yuan to the Dollar to increase exports, it can be argued China is exporting plant shut-downs and job losses over the globe.¹¹ It can also be argued that American businesses which export labor to China — and American consumers who buy the more cheaply made goods are also to blame. The ultimate question to us is — how long can this all continue? When — in a country where 332,000 homes were foreclosed on in October¹² — where more homes have been lost in 2009 than during the roughly 10 year stretch of the Great Depression¹³ — with 7 million more homes potentially to be repossessed by lenders¹⁴ — do increasingly unemployed U.S. workers simply become incapable of buying?¹⁵ And if the goods China produces can no longer be absorbed by the world — we doubt China has the internal demand to make up the difference. At such a point, we believe more Chinese reserves would have to be spent on internal economic stimulus — and less on the purchasing of U.S. Treasuries. And then who’d finance our government debt? (We think the printing press). The potential domino effects are intriguing to say the least. It’s our opinion understanding them could point the way to opportunity.

Does China truly have the advantage over the U.S.? It certainly does provide cheap exports and cheap credit to America. But what if the U.S. raises tariffs — increasing the cost of Chinese goods and reducing demand for them? Would the resulting higher prices paid by American consumers be offset by increased U.S. jobs and wages in such a scenario? Or, would increased U.S. tariffs result in retaliatory tariffs by our trading partners — resulting in declining U.S. exports and economic hardship? Would American corporations with political clout even stand for such U.S. protectionism in the first place?

This is the world we live in as a large-scale game of economic “chicken” seemingly unfolds. With government manipulation of interest rates, money supply, and intervention in trade policies — along with a strong connection between large corporations and legislature (bailouts and tax-policies included) — the free market does not seem so free.

It appears to us that such a shackled market is having a harder time being efficient. And in such an environment come the gross imbalances with their unpredictable consequences we’re referring to.

Stay tuned.

While there is a lot of tough reality going on out there — we maintain our positive outlook. That outlook is based on our belief that a bear market in one thing is often a bull market in another. And bull markets are what we hunt.

As we enter this critical time — now, more than ever — we believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.

Sincerely,

Stephan R. Ernharth, JD, AIFA
Vice President
Ernharth Group

“A warning shot (in nautical terms, often called a shot across the bow)… a harmless artillery shot or gunshot intended to call attention and demand some action.“
—Wikipedia

A Major Shot Fired

In our recent (October 26) commentary “Paper Money Games” we again mentioned our long-term concern over heightened competitive currency devaluation, as countries across the world continue to print and debase their money. And we don’t seem to be the only ones paying attention to this phenomenon. On November 3, it was announced that between Oct. 19 and Oct. 30 the Reserve Bank of India paid $6.7 billion to buy 200 metric tons of gold bullion from the International Monetary Fund.¹ We consider this an extremely significant event since it is the largest known central bank purchase over such a small period of time in the past 30 years.² The news helped drive the price of gold up more that $30 to a record $1,087 an ounce — and as we go to press on November 9, it trades at $1,104.³ In one fell swoop, India has leapt from 12th-largest government owner of gold ahead of Russia into ninth place.⁴

It’s our opinion India’s move is a major shot across the bow of the Dollar, and all world currencies. And we’d not be surprised to see China fire another one as more gold becomes available. On May 5 in “China Accumulates” we reported that since 2003 the Chinese had already increased their holdings in gold from 600 to 1054 metric tonnes — an increase of more than 75% over the six-year stretch, which moved them to 5th (ahead of Switzerland) among nations who disclose their gold holdings.⁵ With vast amounts of foreign reserves, one wonders what the Chinese are thinking now.

The Response?

If India’s purchase (or further purchases by other central banks) are intended to reign in massive Dollar (or other currency printing) — we think such warnings will be in vain. It’s our opinion the U.S. will continue to attempt to stimulate, bail-out, maintain low interest rates, and print money to keep the party going. We hear of a “jobless recovery” (which is kind of an oxymoron to us). And if there is a party going on, it has that 3:00 AM feel where a few hard-core stragglers hang around for “one more round.”

Will India’s large purchase chasten the U.S. and stop the money printing? We don’t think so. As we’ve often stated — we believe a “strong Dollar” policy (including raising interest rates) would impose severe hardship on a staggering, cheap credit dependent U.S. economy with a large trade deficit — and a heavily indebted U.S. government. Thus, it’s our opinion a “strong Dollar” is the last thing the U.S. government really seeks at this time. However, we believe the U.S. government does want foreigners to help continue funding its bailouts, stimulus, wars, proposed health-care reforms — and overall indebtedness by buying more of its debt/bonds. India’s large purchase of gold may be the beginning of a trend where foreigners may be losing their patience for holding large amounts of U.S. Dollar based assets.

Here are excerpts from William Pesek’s interesting analysis of the India gold buy written for Bloomberg:

“Didn’t India get the memo? Developing nations are supposed to keep their excess cash in Treasuries, the U.S. president and his Treasury secretary are no doubt thinking. Gold? That relic of the past that doesn’t pay interest or dividends and can’t be eaten? A fool’s game best left to the dinosaurs out there. India is going its own way with a $6.7 billion gold purchase. The transaction turned heads in markets. It should do the same in capitals from Beijing to Washington. India’s 200 metric-ton deal wasn’t huge considering how much gold central banks hold. It’s the symbolism that matters as the U.S. struggles to keep the dollar’s slide orderly and panic– free. Consider India the vanguard of central banks more aggressively diversifying reserves away from U.S. assets.

As markets brace for that inevitability, here are four things we can conclude from India’s gold rush.

One, the dollar’s plight just got worse. Mounting U.S. debt is bumping up against a dismal employment picture, a toxic mix that may get the attention of credit-rating companies. This U.S. recovery looks to be a uniquely jobless one, complicating things for a president already grappling with two unpopular wars…That raises the specter of even more stimulus spending, more bond issuance and more pressure on central banks to avoid a dollar crash. It’s well-known that Geithner is relying on Asia to continue loading up on Treasuries. Even U.S. Secretary of State Hillary Clinton found herself talking up the bond market in Beijing earlier this year. Yes, talk of the dollar’s death is overdone. There is still no obvious replacement. Yet Asia’s tolerance with falling U.S. assets is evaporating. India’s gold grab from the International Monetary Fund’s bullion stash is the latest reminder of that.

Two, India’s got game. China doesn’t talk much about its currency reserves, yet you have to imagine a few top officials in Beijing are red-faced this week…China seemed the overwhelming favorite to get the first chunk of the gold the IMF is offloading to shore up its finances. A question no one can answer yet is whether India will touch off a bidding war among central banks…Will it be China looking to employ its $2.3 trillion of reserves? What about Japan, which has the second-biggest pile of currency? Or Gulf states working to end dollar hegemony? And let’s not forget about Brazil and South Korea…

Three, the IMF is back. The crisis of the last two years put the Washington lending institution back in business. Now it’s flush with fresh liquidity to help the nations that need it most…

Four, central banks are reverting to the past. Almost 100 years ago, John Maynard Keynes chided India for its “ruinous” love of the “barbaric relic.” Perhaps central banks were reading their Keynes over the last two decades, during which anti-gold sentiment pervaded. The belief that inflation had been defeated made paper currency seem a safe and more practical bet than bars of gold collecting dust. The dollar’s swoon is prompting a bit of revisionist history, putting gold back en vogue. It says much about where the global financial system finds itself…“⁶

[Opinions expressed by William Pesek are not endorsed by NPC. William Pesek is not a representative of NPC or Ernharth Group.]

Getting Out

What will be interesting to us is the Dollar’s fate if foreigners increasingly choose to hold their reserves in gold. We believe an orderly decline of the Dollar is more acceptable to the U.S. and foreigners than a crash. It’s our opinion a Dollar collapse would either force the U.S. government to pay higher interest rates on its debt to keep foreigners buying it — or to print a whole lot more money. As to foreigners, we think they’re certainly aware of the Dollar’s fundamentals — and it’s our opinion they may be looking to get out. They just don’t want to see a collapse before that happens.

We think this is going to be interesting.

As always — our goals are to first and foremost acknowledge the facts — and then, to get on the right side of the trade.

While there is a lot of tough reality going on out there — we maintain our positive outlook. That outlook is based on our belief that a bear market in one thing is often a bull market in another. And bull markets are what we hunt.

As we enter this critical time — now, more than ever — we believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.

Sincerely,

Stephan R. Ernharth, JD, AIFA
Vice President
Ernharth Group

Fiat Currency: Common type of currency issued by official order, and whose value is based on the issuing authority’s guarantee to pay the stated (face) amount on demand, and not on any intrinsic worth or extrinsic backing. All national currencies in circulation, issued and managed by the respective central banks, are fiat currencies.
— www.businessdictionary.com

Fiat Money: Type of currency issued by governments as legal tender, the value of which is based solely on decree or law rather than on actual coin or precious-metal reserves (called specie), and the redemption of which is not guaranteed by the government.
— encarta.msn.com

Competitive Currency Devaluation Ramps Up

We’re of the belief that it’s wise to seek out the observations of those outside the U.S. if you want to get a more complete view of what’s going on in the world. And this includes economics. To those who feel recovery is on the way — we say, not so fast. A quick scan of the world shows us that things are not so rosy everywhere — and we believe investors should proceed with eyes wide open.

On April 10, 2009 in a piece titled “Race to the Bottom” we warned competitive global currency devaluation was upon us — and that foreigners would not idly stand by as the U.S. debases the Dollar in its attempts to inflate (print) its debt away. In a recent piece in the Telegraph.co.uk titled “Euro at $1.50 is ‘disaster’ for Europe” Ambrose Evans-Pritchard writes:

“‘The euro at $1.50 is a disaster for the European economy and industry,’ said Henri Guaino, right-hand man of (French) President Nicolas Sarkozy.’ …What concerns European policymakers most is the lockstep rise against China’s yuan. Beijing has clamped the yuan firmly to the weak dollar for over a year, quietly benefiting from the export advantages… French finance minister Christine Lagarde said it was intolerable that Europe should ‘pay the price’ for a dysfunctional link between the US and China. ‘We want a strong dollar, and we have reiterated it again in the strongest manner.’ …Europe and Japan are now the last two blocs standing as everybody else lets their currencies fall… Brazil has become the latest country to intervene, resorting to controls to cap the real after its 42pc rise against the dollar since March… Switzerland is openly intervening to hold down the franc in order to stave off deflation. Canada and New Zealand have talked down their currencies. Britain and Sweden have opted for stealth devaluations… Korea, Thailand, Taiwan, the Philippines, Indonesia and Russia have all been buying dollars to stem their currencies’ rises…“¹

As we read about the competitive currency destruction above, we can’t help but wonder about the fate of investors whose savings are denominated in paper money.

And, in our opinion, those who wait for a strong-Dollar policy to be instituted by the U.S. may not want to hold their collective breath. With a staggering national debt, a massive deficit, along with the potential for more bailouts — we believe the U.S. Government will choose to continue to print money. In our opinion, it’s either that — or raise taxes and cut spending — both dramatically. And we think neither politicians nor constituents have the will, or the stomach for either of those options. If the U.S. keeps printing, we’d not be surprised to see other countries continue to follow suit to protect their export-based economies. To us, this is simply a function of a world without gold-backed currencies. If this scenario continues to play out — those who hold paper money may want to beware.

Over the past 40 years the Dollar has gained and lost value against other nations’ money. And we ask ourselves — does the Dollar really “strengthen” if it gains value against other currencies which have simply sped up their devaluation process? As we compare prices of anything today against their 1970 (let alone 2000) prices in dollars — and ask ourselves if the Dollar has really gotten “stronger” — our opinion is “absolutely not.” Instead, we see a Dollar which buys far less today than it has in the past. Over time it has simply fallen in value more quickly or more slowly than other paper money which is falling in value too.

As to whether the Dollar retains its status as the dominant currency of the world — we’re more concerned about what the dollar will buy in the future if world currencies continue to be devalued by their respective governments. In other words, what good would it be to be the strongest among the weaker than today? Our answer is “not much” — especially if you can find other alternatives.

Spoiled Brits and Nervous Germans

In Britain we learn the Government is struggling to fight the national financial crisis.² The falling pound has helped exports, but “The pound never stops where you want it to,” stated Sir Howard Davies, Director of the London School of Economics³ — in a warning that perhaps should be listened to in the U.S. as the Dollar plummets. Even more interesting is the apparent phenomena of British citizens seemingly against even a small amount of cut-backs.⁴ Professors are preparing to strike for 8 percent wage hikes — and polls now show 48 percent of the public are against spending cuts of any sort.⁵ We wonder what would happen in the U.S. if broad-based spending cuts in entitlements were proposed.

In Germany we hear “There is still a significant risk of further shocks to the international financial system,” according to a warning from a panel advising the government.⁶ Their report also stated, “Credit to non-financial firms has clearly been declining. Financial conditions are likely to worsen further. Banks are facing large write-offs on toxic debt and a rising toll of company insolvencies…There is a major danger that already tight financing conditions could lead to a credit crunch next year…“⁷ Interesting indeed.

As always — our goals are to first and foremost acknowledge the facts — and then, to get on the right side of the trade. Thus…

While there is a lot of tough reality going on out there — we maintain our positive outlook. That outlook is based on our belief that a bear market in one thing is often a bull market in another. And bull markets are what we hunt.

As we enter this critical time — now, more than ever — we believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.

Sincerely,

Stephan R. Ernharth, JD, AIFA
Vice President
Ernharth Group

“Paper money eventually returns to its intrinsic value — zero.“
— Voltaire

Dollar to Be Replaced in Oil Trading?

In our previous commentary “Dollar Supremacy Slipping?” — we wondered whether the U.S. Dollar’s status as the world’s reserve currency was seriously being threatened. Then, on October 6 things got quite interesting as Robert Fisk reported in The Independent UK:

“In the most profound financial change in recent Middle East history, Gulf Arabs are planning — along with China, Russia, Japan and France — to end dollar dealings for oil, moving instead to a basket of currencies including the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Co-operation Council, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar. Secret meetings have already been held by finance ministers and central bank governors in Russia, China, Japan and Brazil to work on the scheme, which will mean that oil will no longer be priced in dollars. The plans, confirmed to The Independent by both Gulf Arab and Chinese banking sources in Hong Kong, may help to explain the sudden rise in gold prices, but it also augurs an extraordinary transition from dollar markets within nine years.“¹

Fisk’s piece suggests the Dollar may no longer be used for the trading of oil by certain countries.² If he is right, the Dollar’s supremacy may be threatened because it can be argued the pricing of oil in dollars has helped provide the greenback’s dominance globally.

Denials by the Saudis, Japan, Russia, and Kuwait were immediate.³ Saudi Central Bank Governor Muhammad al-Jasser went as far as saying Fisk’s article in the The Independent was “absolutely incorrect,” and sources for Fisk’s article were unidentified.⁴ It’s our belief however, where there’s smoke — there may also be fire. After all, the Dollar has taken a lot of heat due to the ongoing global financial crisis.⁵ And this past June, China and Russia agreed to increase the use of each other’s currencies in trade to lessen reliance on the dollar.⁶ The BRIC nations (Brazil, Russia, India, and China) have also discussed buying each other’s bonds and swapping currencies for the same purpose.⁷ Based on that information — we don’t believe it’s out of the realm of possibility certain nations are considering a plan which would replace the Dollar in the trading of oil. We’ll keep our “Spock-Eyebrow” raised.

Another Threat to Dollar Domination?

In the Telegraph.co.uk Ambrose Evans-Pritchard makes an interesting case for a reason the Dollar’s supremacy may be ending:

“You can date the end of dollar hegemony from China’s decision last month to sell its first batch of sovereign bonds in Chinese yuan to foreigners… Beijing does not need to raise money abroad since it has $2 trillion (£1.26 trillion) in reserves. The sole purpose is to prepare the way for the emergence of the yuan as a full-fledged global currency… It is this shift in China and other parts of rising Asia and Latin America that threatens dollar domination, not the pricing of oil contracts… it makes little difference whether crude is sold in dollars, euros, or Venetian Ducats. What matters is where OPEC oil producers and rising export powers choose to invest their surpluses. If they cease to rotate this wealth into US Treasuries, mortgage bonds, and other US assets, the dollar must weaken over time.“⁸ [Our emphasis added.]

In other words, what’s the incentive to buy U.S. bonds which pay low-interest rates — and risk getting paid back in Dollars which are worth far less (due to America’s inflationary monetary policy)? Especially when bonds can be bought from China — who has its fiscal house in far better order. If countries decide to invest their surpluses in Chinese bonds — as opposed to those issued by the U.S. — who will fund our country’s debt? If that scenario unfolds — it’s our opinion the national debt will be primarily financed by the printing press. And we believe that could have devastating consequences for the Dollar.

While there is a lot of tough reality going on out there — we maintain our positive outlook. That outlook is based on our belief that a bear market in one thing is often a bull market in another. And bull markets are what we hunt.

As we enter this critical time — now, more than ever — we believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.

Sincerely,

Stephan R. Ernharth, JD, AIFA
Vice President
Ernharth Group

“One of the penalties for refusing to participate in politics is that you end up being governed by your inferiors.“
— Plato

“Inflation is the senility of democracies.“
— Sylvia Townsend Warner

FDIC Closer to the Edge?

In our September 4 commentary “FDIC R U OK?” we stated our opinion that the rapid depletion of the FDIC’s insurance fund due to a growing number of bank failures might force the agency to tap the federal government for billions of dollars. Despite FDIC Chairman Sheila Bair’s assurances to the contrary, we wrote:

“If the FDIC’s insurance fund is depleted, the regulator has the ability to access a line of credit at the Treasury Department which was extended by Congress earlier this year to $100 billion — along with the ability to borrow $500 billion through 2010.¹ Chairman Bair has recently said the FDIC doesn’t expect to tap the Treasury line of credit — and that, “The FDIC has ample resources to continue protecting insured depositors as we have for the last 75 years.“² As we survey the heavily jobs dependent housing market, which so many banks are tied into — and add in the faltering commercial real estate market — we don’t believe her at all.”

We still don’t believe her. In a recent interview, Bair stated, “We haven’t made any decisions yet but we are actively considering alternatives to a special assessment (on banks).“³ The FDIC’s deposit insurance fund has dropped to $10.4 billion as 94 banks have been seized in 2009 alone.⁴ The agency, which is mandated by law to raise assets when the fund drops below a certain level, had indicated banks might be required to pay another special assessment by the end of the year.⁵

And now today, September 29, we learn that the FDIC has proposed banks prepay their insurance premiums for the last quarter of 2009, and next three years (through 2012).⁶ And under this new plan, the FDIC would forego charging another special assessment on banks this year.⁷ The proposal has been prompted by FDIC estimates its insurance fund will be in the red by the end of the current quarter — and that bank bailout expenses will reach $100 billion by the end of 2013.⁸ (Note: the FDIC’s prior estimate of bailout costs through 2013 was $70 billion).⁹ The FDIC also estimates the proposed prepayments would raise around $45 billion.¹⁰ Banks are supporting the prepayment plan because premiums paid to the FDIC’s insurance fund are treated as an asset when the payment is made, and an expense in the quarter the payment is due/originally scheduled.¹¹ (You gotta love accounting).

To us, there are so many ominous aspects of the proposed plan, we don’t know where to start. The proposed prepayment reminds us of how low-interest rate financing in the automotive and housing sectors earlier this decade (and “cash for clunkers” more recently) — were used to accelerate economic activity forward from the future. The inevitable trough in activity/revenue eventually does comes though — and then what? To us, accelerating FDIC premium payments by over three-plus years begs the question, “Where’s the money going to come from if there’s another shortfall in the insurance fund?” We don’t have a crystal ball — but we do notice one troubling pattern. And that’s what seems to be an ongoing pattern of under-estimation by the FDIC, the Federal Reserve, the Treasury Department, and the rest of the government as to how bad things really are. If the FDIC’s insurance fund does need to be replenished sooner that expected — what’s next? A special assessment in 2010? Another 3 year pre-payment through 2015? We think not on both accounts. Instead, we pay special attention to House Financial Services Committee Chairman Barney Frank’s statement in a recent hearing:

“This is not the time to raise assessments on the banks… We will have money lent I hope through the fund which will be paid back out of assessments“¹²

To us, phrases like “I hope” don’t exactly actually instill a lot of confidence. But this is where we’re at folks. And to us, it looks like taxpayers may well get a chance to foot the bill once again. Hardly a surprise. We can hear the money printing presses humming already.

Federal Reserve Indicates Stimulus Will Continue

The Federal Reserve Bank has now committed to purchase the full $1.25 trillion of mortgage bonds — after previously stating it would buy “up to” that amount.¹³ The Fed also indicated it would keep interest rates between zero to .25%, stating that rates will remain low for an “extended period.“¹⁴ The Fed’s Open Market Committee statement, indicated the Fed may delay shrinking its $2.1 trillion balance sheet until it secures a recovery.¹⁵ Thus, we believe recent talk of withdrawing government stimulus, seems to be turning out to be just that — talk.

It’s long been our belief the Fed will delay withdrawing stimulus longer than they’ve led us to believe. With the state of the economy, including jobs — we feel any stimulus withdrawal could very likely send the economy into a “Double Dip Trip.” We’d not be surprised next year to see the Fed announce more purchases of Treasury, Fannie Mae, and Freddie Mac debt to keep interest rates low in an attempt to once again juice the economy with low borrowing costs. (Again, all with newly printed money).

Dollar Supremacy Slipping?

In the London Telegraph, Ambrose Evans Pritchard gives this opinion:

“Crucially, China and rising Asia have reached the point where they can no longer keep holding down their currencies to boost exports because this is causing mayhem to their own economies, stoking asset bubbles… A monetary policy of near-zero rates — further juiced by quantitative easing — is completely incompatible with circumstances in most of Asia, the Middle East, Latin America, and Africa… What is occurring is an epochal loss in the relative wealth and economic power of the old G-10 bloc of rich countries compared to rising regions of the world. The euro, yen, sterling, Swiss franc, and other mature currencies will be relegated along with the dollar in this great process of rebalancing, but the greenback will bear the brunt.“¹⁶

Is Pritchard right? He might be — especially if the U.S. keeps printing money to fund its liabilities. (Other than increasing taxes and cutting spending — we see no other way for it to do so). Also, the U.S. — by expanding money and credit, has exported that inflation to its trading partners like China. The Chinese have been all too happy to take our newly printed dollars to expand their economy. Now they face a dilemma. The absorbed dollars are creating inflation in their own country. To cure it — they can choose to let the Yuan float — and gain in value — hurting their exports in the process. This could cost jobs and political stability. Another major problem for China is the massive amounts of dollars it already owns. It’s become increasingly obvious the Chinese are attempting to get rid of them before they drop significantly in value. That’s why we see them purchasing natural resources interests all over the world — along with increasing their gold holdings.^{17 18 19} However, they can’t easily dump all their dollars at once because they’ll likely drive the value of them down. Like a guest at Thanksgiving dinner, the Chinese have happily gorged themselves to excess. But now they’re having trouble getting out the door. And the house may be on fire.

And then there is the U.S. We’ve said it before and we’ll say it again — history teaches us governments tend to repudiate their debt by printing it away. Good for the government? Perhaps. Bad for Dollar holders. Whether they be foreigners or U.S. citizens.

All quite interesting — and in our opinion, full of potential opportunities.

While there is a lot of tough reality going on out there — we maintain our positive outlook. That outlook is based on our belief that a bear market in one thing is often a bull market in another. And bull markets are what we hunt. As we enter this critical time — now, more than ever — we believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.

Sincerely,

Stephan R. Ernharth, JD, AIFA
Vice President
Ernharth Group

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.“
— Charles Mackay

Thinking in Herds

We agree with Charles Mackay’s opinion stated in the quote above. Human beings — like many other animals tend to feel safe in groups. We think it’s a naturally developed biological imperative. The old adage “safety in numbers” probably does work most of the time. We’ve all watched nature documentaries on Animal Planet or The Discovery Channel when herds of thousands of wildebeests or zebras attempt to cross a crocodile infested river. While some of them don’t make it — most do. The same goes for a herd of gazelles being stalked by lions. Odds are that you’re not the one who’s going to be singled out as a target for lunch. Animals who stray from the herd often get picked off. Even predators like wolves and lions hunt in packs and prides with great success. So we certainly understand the concept of strength in numbers.

However, when we look at humans, most of whom view themselves as thinking, rational beings — we notice that some of their most destructive (self-destructive included) behavior is done in large groups. And it starts in their minds. We think of mobs, riots, and war — when people buy into a destructive behavior, often without much thought at all. And we also think of market bubbles throughout history — the 1920’s and 1990’s (tech) — along with the recent bubble in housing. All of which ended badly. Motivators are often fear and greed. As students of history (which we feel is the study of human nature) we’ve noticed when large numbers of people start to think one way — it’s often at a time when they’ve stopped thinking for themselves. In our opinion, it’s precisely at these times when you need to make sure you’re thinking as objectively as possible — and for yourself.

Thinking With What?

We also believe one of the greatest challenges we face as humans, is not to think with our hopes and expectations — but with our brains. It’s our opinion that hope alone is not a good strategy. As we listen to certain folks talk about economic recovery taking place, we wonder if they’re thinking more with their hopes and expectations. Yes, U.S. retail sales in August grew the most in three years — but it was led by rising car purchases prompted by the government’s “cash-for-clunkers” stimulus program.¹ And yes — gas stations, clothing, sporting goods and department stores all reported gains of over 2 percent last month.² But one wonders how much of that growth was due to late summer vacation traveling and back to school purchases. We shall soon find out. We’re paying special attention to the losses shown by furniture and building-material stores.³

We also don’t buy into the belief that the consumer, who’s spending accounts for 70 percent of the economy⁴, is back. Especially after a recent poll published by Bloomberg showed only 8 percent of American adults plan to increase spending, close to one-third will spend less, and 58 percent say they’ll “stay the course.“⁵ The poll also reported that over 75% of people surveyed said they’d spent less over the past year.⁶

Fed-Speak

We’re also paying close attention to what’s being said by the Fed. Chairman Bernanke recently stated, “Even though from a technical perspective the recession is very likely over at this point, it’s still going to feel like a very weak economy for some time.“⁷ He also said, “Unemployment will be slow to come down” if growth ends up being “moderate.“⁸ To us, this sounds like a man carefully selecting his words — and hedging his bets. What it does not do for us is instill confidence that economic recovery is around the corner.

In a recent speech, Federal Reserve Bank of San Francisco President Janet Yellen stated, “We face an economy with substantial slack, prospects for only moderate growth, and low and declining inflation… We need to defend our price stability goal on the low side and promote full employment… I expect the recovery to be tepid… The gradual expansion gathering steam will remain vulnerable to shocks.“⁹ Regarding unemployment, she stated that it would remain “elevated for a few more years.“¹⁰ This sounds to us like a Fed official calling for more money printing and stimulus because she fears the good old-fashioned deflation which seems to want to occur.

When we digest what both Bernanke and Yellen are saying, we remember the Fed’s tendency (in our opinion) to understate how bad things really are. Remember this quote from Chairman Bernanke in July 2005?

“Well, I guess I don’t buy your premise (that housing is in a bubble which will burst). It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So what I think is more likely is that house prices will slow, maybe stabilize: might slow consumption spending a bit. I don’t think it’s going to drive the economy too far from its full employment path, though.”

Seriously though, how could a man that smart be that wrong? In our opinion he was either badly mistaken — or he’s a cheerleader. We suspect the latter, and therefore raise the “Spock Eyebrow” most times we listen to him speak. Thus, as we revisit the quotes above from both Yellen and Bernanke, we suspect things may be a whole lot worse than the Fed’s letting on.

In our opinion deflation (money contraction) is the natural tendency after decades of inflationary money printing. However, our regular readers know we believe the Fed will print money like mad to avoid such a deflationary scenario. Our belief is based on history’s lesson that overly indebted governments tend to repudiate their debt by printing it away. The last thing a massively indebted U.S. Government wants is to pay the trillions of dollars it owes with a stronger currency. Thus, we believe it will do whatever it takes to dilute the it owes with a stronger currency. Thus, we believe it will do whatever it takes to dilute the value of the Dollar. That’s your Dollar.

Golden Canary

Back in November 2008 in “Canary in a Coal Mine” we wrote:

“Just like the Canary who warned miners about too much poisonous gas — we believe that Gold has, for the past 94 years been trying to warn investors that there is too much of another potentially deadly thing — an overexpanding supply of U.S. Dollars. This decade, with massive money printing hitting overdrive — the golden canary seems to be telling us to get out of the mine — and fast.”

As we write, the Golden Canary is trading at $1018 an ounce. What does it know? We shall see.

While there is a lot of tough reality going on out there — we maintain our positive outlook. That outlook is based on our belief that a bear market in one thing is often a bull market in another. And bull markets are what we hunt.

As we enter this critical time — now, more than ever — we believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances. Others may feel free to contact us to learn more.

Sincerely,

Stephan R. Ernharth, JD, AIFA
Vice President
Ernharth Group