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February 21, 2005

The Nation that Debt Built
by Dan Denning

"America may be the dominant force in the global economy because we're a nation made of somewhat Crazy Eddies-gonzo businessmen and women who may be genetically predisposed to take big-time risks," says Daniel Gross in his review of a new book, The Hypomanic Edge: The Link Between (a Little) Craziness and (a Lot) of Success in America.

Gross writes a great review of what sounds like an interesting book. But today we wonder if American's might be a little too crazy for their own pocketbooks. The book, by John D. Gartner concludes that, "many of the components of the archetypal American character-optimism, entrepreneurial energy, religious zeal-fit the hypomanic profile." Gartner says writes that because America began as a nation of immigrants, Americans may be "culturally and genetically predisposed to economic risk."

Whether it's genetic or not, Americans are taking on more risk than ever. Here a risk, there a risk, everywhere we look we find a whole nation at risk. Investors, new homeowners, and would-be retirees take on big risks with Puritanical zeal.

What a moment in financial history we observe, dear reader. A quick scan of today's headlines show all the large themes of globalization and history picking up speed and converging. Americans are getting older, and realizing they can't pay for rising health care costs, or for the comfortable retirement of the Baby Boomers.

China has overtaken the United States in consumption of basic agricultural and industrial goods. It's pushing OPEC to max its output. The competition for the world's oil gets more intense with every passing day. But China itself must compete for oil with India and Japan. All this competition is one reason why buying long-dated oil calls is so appealing.

But the flip side of the contest for the world's energy resources is the impending crisis in America's retirement resources. American policymakers are finding out, quite plainly, that State-sponsored retirement schemes are unsustainable. Alan Greenspan said it yesterday in his prepared remarks to the Senate Banking Committee. The Chairman came out swinging for personal retirement accounts. He told Senators that "the existing structure is not working," and that personal accounts were "a good thing to do over the long run."

The nitty gritty of it is that the near future will find too few workers paying too many retirees too much money. Or, if you prefer Fed speak, the "benefits promised to a burgeoning retirement-age population under mandatory entitlement programs, most notably Social Security and Medicare, threaten to strain the resources of the working-age population in the years ahead...the demographics are inexorable, and call for action before the leading edge of baby boomer retirement becomes evident in 2008."

Greenspan also warned that if the problem isn't dealt with now, it might drive long-term bond yields up. Perhaps the Chairman has been following the great bond debate between the at-odds editors of the Rude Awakening. Short-term rates have risen, but long-term rates haven't, even as America racks up a $600 billion trade deficit. Even Greenspan is befuddled. "For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience."

We will save you the wait and point out that recent experience aside, when a nation becomes a credit risk, bond yields go up. There may be many small reasons to explain why yields are not rising today. But tomorrow, we find it hard to imagine a scenario where it gets cheaper for the indebted American government to borrow for increasingly expensive social welfare plans, not to mention global warfare plans.

Alarmingly, it's not even Social Security that may blow up the yield curve on the long end. It's Medicare. A new Harvard study reports that since 1990, medical spending in America has gone up from $696 billion to $1.7 trillion last year, or about 15% of GDP. The Bush Administration's prescription drug benefit is going to end up adding another $1 trillion to the Medicare burden in the next ten years.

Not only is Medicare going to eclipse Social Security in terms of Federal spending, it might go bankrupt even sooner. The Harvard study projects that if the Medicare hospitalization trust fund will run out in 2019, well before the Social Security trust fund.

How do stocks react to all this gloomy sociopolitical forecasting? They go up, of course. A new Merrill Lynch survey shows that global fund managers are bullish on stocks and pouring cash in. The survey of 320 fund managers found that one in more had over 65% of their assets in stocks and that the average stock allocation was 55%.

Yet foreigners actually bought $27.8 billion less in U.S. financial assets in November, according to Treasury Department figures released yesterday. Foreigners still bought about $61.3 billion in financial assets. But analyst Peter Frank at ABN Amro said, "It was a steep drop, but the market had already been expecting a much smaller number. If that's the start of a pattern, it's bad news for the dollar."

That sounds familiar. Bad news for the dollar. Bad news for interest rates, eventually. And bad news for anyone who depends on the American consumer for economic growth. But even that may be changing.

China has overtaken the United States in the consumption of basic agricultural and industrial goods, according to a survey from the eccentrically named Earth Policy Institute. According to the survey, China consumed 64 tons of meat in 2004, while McDonald's gorging Americans only choked down 38m tons of red meat. China used up 258m tons of steel, compared to 104m in America. And China burned 40% more coal than America.

Granted, on a per capita basis, Americans are probably not cheating themselves at the dinner table (or at the breakfast table, or at the lunch counter, or at the snack bar, or at the desert cart.) And granted, China gets more energy from coal than America because China has a lot of coal. With oil above $45 it is cheaper to burn what you own than buy what you don't.

But don't think the Chinese are backing away from the oil sweepstakes. OPEC said yesterday that rising Chinese demand would force the cartel to boost global output to 30.1 mbpd. OPEC's capacity, by the way, according to the OECD is about 31.5m bpd. Not much slack is there?

In two stories we see two proofs of the same idea. Everyone knows Social Security is going bankrupt, but pretends otherwise. Everyone knows there are more competing for oil that's already being pumped at peak capacity. Prices have risen, but geopolitical temperatures haven't, at least not yet.

Here's the question: at what point does a future inevitability become a clear and present force on asset prices? When will the lurking knowledge that the American government has made promises it can't (and has no intention of keeping) propel U.S. bond yields into double digits? And when will the nervous struggle for the world's oil, conducted politely and with fake smiles and behind the scenes deals for access, turn into an ugly public spectacle? Or are we already watching the opening act?

P.S. We scarcely mentioned Fannie Mae and Freddie Mac. They have exited stage right in the mind of investors as the oil and bond stories take center stage. But if there is an unassuming villain in this drama, it's the GSEs. A sharp and unexpected spike in long-term yields would be just the plot twist to rip the mask off of America's financial economy and begin the sudden popping of its many bubbles.

Kind of reminds you of Hamlet at the end when all the main chracters die on stage. Fortinbras, the King of Norway arrives on scene and speaks the final lines of the play:

"Take up the bodies. Such a sight as this becomes the field, but here shows much amiss. Go bid the soldiers shoot."

Dan Denning
The Daily Reckoning

Dan Denning is the editor of Strategic Investment, one of the most respected "big-picture" investment newsletters on the market. A former specialist in small-cap stocks, Dan has been at the helm of Strategic Investment since 1999 - where, drawing from his network of global contacts, he has designed an investment strategy that takes into account global political and economic trends.

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