The credit rating agency Moody's is repeatedly warning that the cost of the new tax cut deal between President Obama and the incoming Republican congressional leadership may be the US government losing its "Aaa" credit rating within 2 years. Moody's warns that the tax cut deal - in combination with soaring pork barrel spending - will raise the US federal government debt as a percentage of GDP from around 62% today, to about 72-73% in 2012, meaning the US ability to repay the debt is growing increasingly problematic.
Unfortunately for us all - Moody's (once again) has it backwards. As we will simply illustrate herein, the counterintuitive reality is that the greater the deficit - and the higher the US debt relative to the economy - the higher the long term credit quality of currently outstanding US Treasury bonds. The more irresponsible the politicians - the lower the percentage of the future economy that will be represented by current long-term US government debt.
Moody's warning is based on a common mistake when talking about the US budget deficit. Simply put, countries that can borrow in their own currency - such as the US government contracting to repay its debts to Japan not in yen but in US dollars - rarely go bankrupt. They debase the value of their currency, and easily repay their creditors with money that is worth much less. US government spending is currently being funded by the straight up creation of new money out of thin air, and the worse the situation gets, the greater the rate of inflation, and the lower the burden of repaying current debts with much cheaper future dollars.
The implications for investors are potentially catastrophic, and arguably much worse than a "mere" default on the US public debt. Indeed, wiping out debt through inflation doesn't just pay off the US debt, it wipes out the value of all savings and all debts that are denominated in US dollars. Add in the damage to economic growth in a highly inflationary environment, and stocks get wiped out as well. This three way destruction of the value of money, value of bonds and value of stocks is catastrophic to most investors - but also has the potential to create real wealth in often unexpected ways for those investors who, unlike Moody's, take a reality-based approach to the soaring US budget deficits.
Alice In Wonderland & Impossible Government Promises
Let's start with the graph below, which illustrates the problem that Moody's is concerned with.
With federal debt equaling 62% of GDP in 2010, the US is already very much in perilous territory when it comes to a credible ability to repay debt so long as a dollar is worth a dollar. The 1-2 combination of tax cut extension with a veritable pork fest of new spending means that deficits have to continue to soar, and in Moody's view, the net effect is to substantially push up the chances of US government default.
Seems straightforward enough, but let's take a look at the bigger picture. Federal government spending is out of control, and while there is lip service by both major US political parties about bringing deficits down - nobody is actually either cutting spending or raising taxes to do so. To hold together the facade of an economy in recovery, 9% of the total US economy currently consists of the Federal government spending money that is created for it by the Federal Reserve.
This monetization process has been used by desperate governments now and then over the centuries, and it has the usual effect of wiping out a good chunk of the value of the nation's currency through high inflation, or sometimes effectively all of the value of the currency via hyperinflation. At the same time, however, this high rate of inflation also has an important side effect - it wipes out the real cost of repaying a nation's debts. Debasement of the value of the currency is the time-honored method for nations to repay their debts in full on the surface, while in fact stiffing their creditors through repaying them with cents on the dollar, when we account for how much less the currency becomes worth.
This well-established method is why many smaller or less credit-worthy nations can't borrow outside of their own nation in terms of their own currency. Such a nation that needs to borrow from abroad because the government can't pay for internal spending must make repayment promises in terms of a currency they don't control (commonly dollars, yen or euros), so foreign investors can be sure that ye olde traditional debasement of the currency isn't how the bonds will actually be repaid.
As the (formerly) unchallenged economic superpower of the world and issuer of the world's reserve currency, the United States has been in the advantageous position of being able to borrow from anybody in US dollars, as the chances of repaying through currency debasement were considered to be slim. That situation has been changing rapidly since 2008. Indeed, since September of 2010, the US has been openly threatening to destroy the value of the US dollar if necessary, in an attempt to lower the value of the dollar and make the US economy more competitive on a global basis. How this works, and the tragic implications for older savers and investors in particular, is described in my article linked below: "Bullets In The Back: How Boomers & Retirees Will Become Currency War Casualties".
The Federal Reserve is currently creating out of thin air about $1,000 a month for every household in the US, as part of its funding of US government deficits. This is highly inflationary, and the resulting inflation will have the effect of meeting other government goals as well. As illustrated in my article from last year, "Bailout Lies Threaten Your Savings" (linked below), the total real debts of the US government long ago passed the point where repayment was believable. Make a dollar worth a nickel, however (thereby annihilating the value of most retirement pensions and retirement portfolios), and the impossible becomes possible.
This time-honored principle of high inflation rates debasing the currency and thereby making the repayment of staggering debt levels surprisingly affordable, is what Moody's and much of the market is missing. The graph below illustrates what is meant when we say that extraordinarily inflationary actions - such as manufacturing money of thin air to fund 9% of the economy - can lead to the end result of reducing the debt burden relative to the economy.
Moody's assumes that a dollar remains worth a dollar, and if it does, then we have the far left column, which shows a debtor nation owing 72 cents on the dollar when comparing debt to GDP, with a questionable ability to fully repay.
But what happens if highly inflationary actions lead to a dollar being worth 50 cents? Then we have the second column, where the GDP has doubled (in nominal terms) with inflation, but the principal amount of the debt remains the same. Therefore, the irresponsible actions that dropped the value of the currency in half - also dropped the value of the debt relative to the national economy from 72% to 36%. Counterintuitive though it may seem, this means that a nation borrowing more than it can repay (in its own currency) can lead not to bankruptcy, but rather an enormous increase in credit quality.
Following the same principles, if a dollar becoming worth a quarter means that 75% of the inflation-adjusted value of the nation's debt is destroyed, then debt drops below 20% of GDP - and repayment becomes a cinch.
With a future dollar worth 10 cents, the debt to GDP ratio drops below 10%, and the US pays off all current debt principal with ease.
With a future dollar worth a penny, the current debt to future GDP ratio is below 1% and the US can pay off everything it owes inside of a year, and almost without effort.
It may look like Alice in Wonderland - but this is how debasement of the currency in order to repay the debt works. Sovereign nations that can borrow in their own currency are not at all like ordinary people, corporations, state and local governments, or small nations that must borrow in other currencies. Simplistic analyses that treat a nation like a corporation can lead to grievous errors during a time of global economic upheaval, and Moody's has this dead backwards. The worse it gets, and the more reckless the government actions in ratcheting up impossible debts - the easier the current debts become to repay, and the less of the future national economy that must be devoted to the repayment of today's debts.
That may sound surprisingly advantageous for US taxpayers - but quite to the contrary, the full implications are a nightmare scenario for us all.
The Cost Of Soaring Credit Quality For The US Government
While the economic process described above may look like a pretty slick trick, there can be other costs that are high indeed for the nation, the economy, and most of all, for the unfortunate citizens of the nation that just "stiffed" investors on a global basis.
On a national and economic level, GDP is highly likely not to be constant once we adjust for inflation. High rates of inflation are incompatible with economic growth, and will likely lead to a declining GDP. As an example, the economic disruption associated with the dollar quickly losing 75% of its value might by itself pull down real GDP (as a round number example) by 25% as well. There is still a radical reduction in the debt to GDP ratio, but it would be down to 24% rather than the 18% illustrated. This is far from a winning situation for the citizens of the nation, as a 25% reduction in the average standard of living is far more expensive than simply repaying the debt would have been.
So long as the dollar falls faster than the economy - which is quite likely - then the credit quality of the outstanding debt is indeed higher for the reasons shown, but the citizens pay a devastating price with a decline in real wealth from a shrinking economy that might very well exceed the cost of repaying the debts without inflation.
The "successful" implementation of a repay-debt-via-currency-debasement strategy can also have long lasting implications for a nation in its ability to borrow, both domestically and internationally. Funding government deficits becomes almost impossible, because nobody trusts the government for years to come. Therefore the nation is likely to be constrained to spending no more than it can take in via taxes - meaning it can't borrow or monetize to meet social wealth redistribution promises. Examples of such promises include Social Security, Medicare, and extending unemployment benefits without limit.
This destruction of the government safety net is most unfortunate, because another side effect is the devastation of the private investments that hard working and responsible people have been buying to survive the failure of Social Security and Medicare. What is illustrated above goes right to the heart of what I have been educating readers about for years, and what I have been developing strategies to deal with for years. Simply put, there is only one US economy, not one economy for broken government promises, and another economy for fantastic performance by conventional investment strategies.
The government will predictably meet impossible promises by paying in form but not in substance. This means that rather than default, the US government will likely pay principal and interest in full, but these payments will be made in dollars that are worth far less than they are today. The ripple effects of this debasement of the currency are catastrophic for savers, bond investors and stock investors. Meaning public safety nets and the viability of most private investment strategies collapse together, leading to long term impoverishment for tens of millions of retirees and Boomers who did nothing wrong.
Given the current grave peril to the value of the Euro, there are also powerful implications resulting from the application of these same principles for European Monetary Union members, as discussed in my article from last spring linked below, "German Windfall Profits From Exiting The Euro."
Who Pays The Cost
A collapse in the value of the currency necessarily forces a major redistribution of wealth, and the segment of the population that is most devastated by this seems to always be the same. It's the retirees, and the people close to retirement. When we look to Germany, when we look to Argentina, when we look to Russia - it is the pensioners who are impoverished more than any other group.
Sadly, history is repeating itself again. When we look at the headlines about the destruction of retiree investment values, pension assets and so forth, we're really just seeing the beginning. That is because the crisis "solution" that is being chosen - creating dollars without the ability to pay for those dollars - essentially represents the annihilation of most of the retirement dreams of the baby boom generation, even if that is not yet recognized. There is not an even cost that is being born by society as a whole, rather some segments are bearing much more of the burden than others. If your peer group (particularly Boomers and older) is headed for disproportionate financial devastation, then happenstance is unlikely to offer a personal way out. Instead, you must instead take quite deliberate actions to change your personal financial position so that the more of the value of the dollar that is wiped out - the more wealth that is redistributed to you, rather than away from you.
A simple and increasingly popular solution is to pull all you can out of paper investments and symbolic currencies, put them into gold, and hunker down to survive the storm that is building in strength by the week.
Unfortunately, however, we live in a complex and deeply unfair world, that makes mincemeat of emotional reactions and simple solutions. As illustrated in step-by-step, easy to understand - but irrefutable - detail in the article "Hidden Gold Taxes: The Secret Weapon Of Bankrupt Governments" linked below, a simple solution of just buying gold leaves you handing a good chunk, or perhaps most of your starting net worth, over to the government by the time all is said and done. The way the government - under existing laws - effectively confiscates the wealth of gold investors in a highly inflationary environment is little understood by most gold investors, but should form the central point for their investment strategies.
Let me suggest an alternative approach, which is to study, learn and reposition. To have a chance, you must learn not just how wealth will redistribute, but how unfair government tax policies (that can be relied upon to increase in unfairness) will cripple most simple methods of attempting to survive inflation.
Then, yes - buying gold (and perhaps a lot of it) can be one key component of a portfolio approach, as discussed in my Gold Out-Of-The-Box DVD set. Use multiple components, each doing what they do best, shift the components in a dynamic strategy over time, and position yourself so that as inflation wipes out current government debts along with most people's savings - wealth will be redistributed to you in a manner that reverses the effects of government monetary and tax policy.
Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation - the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? Do you know how to potentially triple your after-tax and after-inflation returns through Reversing The Inflation Tax? So that instead of paying real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? These are among the many topics covered in the free "Turning Inflation Into Wealth" Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at DanielAmerman.com or InflationIntoWealth.com.