Government Debt: Termites in the House

Government Debt: Termites in the House
by Bud Conrad
The Daily Reckoning
Thursday, July 20, 2006

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• Choose your own opinion…trying to make sense out of mixed headlines…

• If only we had more hands…a "gold mine" in your mouth…

• Why shouldn't there be a "soft landing" for housing?…an interesting proposition for your editor…and more!

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The problem is anatomical.

Will the Fed raise rates next month? Or lower them?

We have, helpfully, given both opinions in these pages. Dear readers can choose the one they prefer.

On one hand, rates would be raised, we guessed, because it is only by fighting inflation at the short end of the yield curve that lenders out on the other end are encouraged to continue lending at low rates. It is only low mortgage rates that can keep the housing bubble from popping. And it is only the housing bubble that keeps the economy from falling apart.

On the other hand, in bringing up his troops to fight inflation it seems that Ben Bernanke has faced them in the wrong direction. It looks like the housing bubble is already losing air. Of course, we have thought so for a long time. But sooner or later we are bound to be right. Why not now? And we further presumed that when the housing bubble really begins to deflate, the Fed will panic…and cut rates.

But listening to Ben Bernanke's congressional testimony yesterday, we came away with the idea that even the Fed chairman doesn't know which hand he will raise. He seems to be reading the headlines, just as we are. He calls it "data dependent." If the news is good, in other words, he will raise rates. If it is bad, he will lower them.

So far, the headlines are mixed. On the one hand, producer prices were higher than expected. And the core inflation rate is now running at 3.6% annually. But on the other hand, the stock market surged yesterday. As Bernanke gave his little speech, it looked like the odds of another rate hike were shrinking, which gave heart to the bulls and discouraged the bears. And news came from California that, despite falling sales, house prices were still going up.

And, if we had yet another hand, headline stories from across the nation about sagging real estate would be on it. "Housing starts fell 5.3% in June," says Bloomberg. "Mortgage applications fall 4.5%," adds CBC. "Housing market's in trouble," continues the news from Chicago. Even from Shanghai comes a report that "Luxury flats empty." The Chinese, ever cryptic, feel no need to elaborate with verbs.

Still, we were able to read the signs of the time from an enterprising Frenchman who has lived in China for the last 10 years - running a furniture factory. What's going on there, we wanted to know.

"It's an interesting place," he told us. "When you've been there for a year or two, you think you've got the place figured out. But the longer you stay there the less you understand.

"You can make a lot of money. You can lose a lot of money, too. You get numbers from Chinese companies, but you never know what is behind them. And if you try to follow the rules, you soon learn that the rules are changing all the time. You never know what they are. I finally realized that the best way to do business in China is just to do it…and don't ask any questions."

According to the numbers, the Chinese economy is growing at its fastest pace in 10 years, more than 11% GDP growth annually. What is behind the numbers, we don't know. But from what we read, most of the growth comes from massive capital investment - building factories to make things for people who can't pay for them. The United States is China's major export market. When consumers in America finally feel the pinch of rising fuel costs and falling housing prices, the boom in China will be over. Look out below.

"The Chinese have to redirect their economy toward domestic consumption," said Stephen Roach on television yesterday. Yes, indeed.

And, in the words of our president, Kofi has to get Assad on the phone and tell the sonofab**** to tell Hezbollah to stop this sh**. And, to steal a thought from a man with too many of them, all that the public-spirited Iraqi "opinion leaders" have to do is to delegitimize terrorism. Americans have to restore balance to their current account, we add, by not spending so much money.

And none of it is going to happen until it is forced to happen. That is, until a hand or two has been chopped off.

Meanwhile, one in four Americans is falling behind on his monthly payments, which tells us that the day cometh and soon is.

So what do we know? The Fed is raising rates…or lowering them. Inflation is mounting…or declining. Stocks are going up…or down. If only we had more hands.

As we said earlier, we try to be helpful.

[Ed. Note: Today's markets and headlines are so filled with uncertainties and contradictions, it's hard to know what to believe. That's why we've gathered ten of our top Wall Street analysts, traders and visionaries to share with you their vital advice and recommendations for the remainder of the year in a revolutionary new format. Find out all the details here:

You Can't Afford Not to Listen

More news from The Rude Awakening…

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Eric Fry, reporting from New York:

"China is exploding; the Middle East is imploding; oil must be a 'buy'…at least on dips. And if oil is a 'buy,' oil stocks must also be a 'buy'…at least on dips."

For the rest of this story, and for more market insights, see today's issue of The Rude Awakening:

Wall Street's Woeful Wisdom

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And more of what we happen to be thinking about…

*** A colleague came across this note in a West Virginia newspaper:

"A Gold Mine in Bedroom Drawers: People are selling their old scrap gold that is gathering dust for its cash value because gold prices are so high…ScrapGold.com, a gold recycler, offers free insured recycle kits so people may cash in their scrap with 24 hour service and guarantee satisfaction. 'Everyone has bits of gold just lying around which can be turned into cash,' says Richard Zakroff, VP of marketing. 'Even old dental gold has value.'"

So, good news, dear reader: you can turn your gold teeth into a nice profit!

*** Soft landings…yes…soft landings. Now that the condo flippers are flipping less often, the word on the street is that the real estate dirigible is coming in for a very soft landing. It reminds us of the approach of the Graf Zeppelin over Lakehurst, NJ. It seemed to float, majestically…until a spark of static electricity ignited a leak and set the big hydrogen-filled balloon on fire. In seconds, the whole ship was in flames and crashed to the ground. Of the 97 people on board, 35 were killed.

Why shouldn't there be a soft-landing in housing? Again, it is a problem of anatomy, and topography, in our opinion. The knee bone of consumer spending is still connected to the leg bone of the housing market, which is still connected to the anklebone of easy money, and a lot of it. The lower limbs run along nicely as long as they are going down the gentle slope of declining interest rates. But when the ground turns up, the pace slackens. In some parts of the country, four out of five people who bought houses in the last two years did so with ARMs - adjustable rate mortgages. On the downhill run, they glide along.

 But woe on the upside. The Fed has aggressively moved up rates - 425 basis points over a two-year period. This is the biggest percentage increase in the fed funds rate in the last 44 years. All of a sudden, borrowers face a steep incline. The hot weather and high energy bills don't make the going, which used to be so good, any better. We wait to see how many fall on their faces.

*** The Eurostar let us down yesterday. A train broke down en route from London to Paris. Our train, immediately behind it, was forced to wait…and wait…and wait…until finally creeping into town at two in the morning.

Which was a pain in several ways, because the subway had stopped running and the cabs had disappeared. And then, it started to rain.

Oh the travails and hardships we endure on your behalf, dear reader. It was so late, we figured we might as well walk over to the Follies Bergere, order a bottle of champagne and catch the last show. But duty called. We had to write in the morning. And duty must be obeyed. We put our bag over our shoulder and set out.

Paris is beautiful in the rain. The streets glisten. At 3am, the city was quiet and there was hardly anyone about besides us and a few bums and prostitutes. We thought we saw one of the women who used to work over by our old café, the Paradis. She was large enough. Old enough, too…at least 65. And ugly enough. We were about to say hello, when drawing near to get a good look, we realized it was someone else.

"Monsieur, you look like you could use a little relaxation," she said.

"Well, actually, I need to go to bed," was our reply.

"Just what I was going to suggest," she shot back.

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The Daily Reckoning PRESENTS: Casey Research's Bud Conrad recently had lunch with David M. Walker, head of the U.S. Government Accountability Office (GAO) and then followed up with him on the outlook for the U.S. economy, especially as it relates to deficit spending. His report follows, below.

GOVERNMENT DEBT: TERMITES IN THE HOUSE
by Bud Conrad

Recently I had the pleasure of having lunch with the Comptroller General of the United States, David M. Walker. He heads up the U.S. Government Accountability Office (GAO), the government's internal watchdog. As he was about to give a talk on out-of-control government deficits, he had in his briefcase a chart on the size of the government's obligations over time. Our discussion about those obligations over lunch was followed by an email exchange, and Walker kindly helped me source additional GAO data, all of which allowed me to confirm my analysis of the budget with projections from the Congressional Budget Office (CBO).

I have also met with Douglas Holtz-Eakin, head of CBO, who can competently recite the situation of six different budget projections without notes. The combined scenarios of the GAO and CBO provided me with the basis to create the following projection of the U.S. budget:

A clear picture emerges of a government completely out of control. The blue line is the history of the U.S. Federal Government debt. The green line shows the path we are now on, with debt soaring to impossible levels against projected GDP. Importantly, the source isn't some crazy hand-waving blogger: these are the government's own projections - and we all know they have every incentive to accent the positive. If this is the best they can do at this point, then you know things are not just bad, they are calamitous.

This glimpse at the future clearly shows that the debt of the U.S. will, in the foreseeable future, go from being a troubling yet manageable fraction of the economy to being several times the size of economy. That can't happen without serious repercussions.

The government will be spending money they don't have, which means creating more of it out of thin air and diluting the value of all the dollars that came before. It doesn't take a Harvard MBA to know that the kind of deficits projected above guarantee a persistently weak dollar, higher inflation and higher interest rates going forward.

You may be right to criticize this analysis as only one of many scenarios being developed all the time and that there are other assumptions that lead to other estimates, and you would be right.

But I've looked at the assumptions, as has David Walker, and it is more likely that the assumptions have underestimated how serious the situation could become, maybe by a significant margin. For example, in the projections above, the interest rate paid by the government stays flat. Interest rates fell for 23 years and have only just recently bounced off of 45-year lows. The odds of interest rates staying at these low levels for decades into the future are, in my opinion, nil. I have analyzed the scenario of the impact of higher interest rates. The problem can get out of hand because it feeds on itself: higher interest rates lead to higher interest on debt, which leads to higher debt, which leads to greater loss in confidence in the dollar, which leads to higher interest rates… and the loop makes itself worse.

Who is responsible for this sin of profligate spending? You could start by pointing a finger at the House of Representatives as they are constitutionally charged with holding the purse strings of the U.S. government. They voted for the spending and programs we are now saddled with, they pass tax programs, and vote in the big supplemental bills that fund the wars.

Entrusted with allocating the biggest sums of funding in the world, they clamor for more and, in the process, act like termites chewing away at the fiscal underpinnings of the economy, assuring the future bankruptcy of the nation. And it is not just the modern politicos that are responsible, but a failure to pursue sound monetary policies that extends back decades. Why do they do it? That answer is easy and reflective of human nature… they do it to curry favor with their constituents in order to get reelected.

Which further points the finger at us, the American public, who instead of voting the bums out for wasting our money and handing a legacy of debt to our grandchildren's grandchildren, happily pocket the pork belly doled out and reward the most prolific spenders with our votes.

The bottom line is that debt and deficits are baked into the cake, exacerbated by the demographics of retiring baby boomers and a government that not only shows no intention of slowing its spending, but quite the opposite. In fact, like a penniless smoker breaking a child's piggy bank to buy a pack, the debt-addicted government has already spent the supposed "Trust Funds" of Social Security and Medicare.

The government is closer to bankruptcy than anyone who has not studied the situation can guess. You will hear government apologists claim that the government can't go bankrupt because they are the government, and along with a complicit Federal Reserve, they can meet any debt obligation because they have the printing press. That is precisely the problem. They can print any amount of money they want. That has been theoretically possible since we went off the gold standard in 1971.

It is this loss of any constraint on government spending that has let the genie out of the bottle. The track is now laid. The long-term future of the dollar is not in question. And to the extent that it is the basis of all other currencies, the reserve currency of the world's central banks, all currencies are doomed.

Gold and the quality companies that produce or competently explore for it should no longer be viewed as entertaining speculations, but as portfolio requisites.

Regards,

Bud Conrad
for The Daily Reckoning

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Bud Conrad holds a Bachelor of Engineering degree from Yale and an MBA from Harvard. He has held positions with IBM, CDC, Amdahl, and Tandem. Currently, he serves as a local board member of the National Association of Business Economics and teaches graduate courses in investing at Golden Gate University. Mr. Conrad, a futures investor for 25 years and a full-time investor for a decade, is also a regular lecturer for American Association of Individual Investors. As a senior researcher for Casey Research, LLC, he produces original research and analysis for the International Speculator.

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