The Debt Ceiling And Implications For Gold Investors

The flood of news about the recent US government shutdown and the debt ceiling triggered a discussion between Claudio Grass from Global Gold and Pater Tenebrarum from Acting-Man. The consensus between both was that most news items and analysis miss some key points. In some cases, the consequences of the worst case scenario are overestimated (resulting in doomsday expectations), while in others the seriousness of the debt “ceiling” has been overestimated. Besides, the potential outcomes in different scenarios after the events remain rather underexposed. These observations led to a thorough analysis, but one from an Austrian perspective, written by Pater Tenebrarum. This is a must read for physical gold investors.

Anyway, the president and his party (who naturally wish to see the debt ceiling increased sans conditions, i.e., they want to be free to continue to spend with both hands) have decided it is time to play the ‘default scare card’. We should perhaps point out here that a ‘ceiling’ that keeps getting raised is not a ‘ceiling’ at all, so one wonders why it was created in the first place.

On the other hand, because the debt ceiling occasionally provides us with wholesome diversions such as government shutdowns, we must admit it is not an entirely useless piece of legislation. In fact, what we have here is a rara avis that successfully combines entertainment with education. One might call it an infotainment bill.

Pater Tenbrarum continues …

While it is true that a default by the US government would have grave repercussions – for instance, it may well end the dollar’s dominance as the world’s reserve currency, which is an extraordinary privilege enjoyed by the US – a failure to raise the debt ceiling won’t lead to a default unless the treasury decides to default voluntarily.

The only thing that needs to be done to avoid a default is to merely stop deficit spending. The US treasury takes in some $2.4 trillion in tax revenue every year. That should give it plenty of scope to both continue pay interest on its existing debt as well as paying the principal on maturing debt (note that it can also issue new debt as long as it repays old debt and thereby remains within the limit imposed by the ‘ceiling’).

In fact, the only thing that would happen if the ceiling were not raised is that it would finally morph from the joke it currently is into an actual ceiling. Of course this would also imply that there could be no more spending growth and that nearly all discretionary spending would have to be stopped. The government’s size would shrink by about a third, to where it was – 10 years or so ago perhaps?

However, one thing that the recurring wrangle over raising the phony debt ceiling shows, is that there is absolutely no intention to ever reduce the debt mountain or – gasp! – actually repay the debt or even a portion of it. As Ludwig von Mises wrote about the nature of government debt (in ‘Human Action’)

“But if the government invests funds unsuccessfully and no surplus results, or if it spends the money for current expenditure, the capital borrowed shrinks or disappear entirely, and no source is opened from which interest and principal could be paid. Then taxing the people is the only method available for complying with the articles of the credit contract. In asking taxes for such payments the government makes the citizens answerable for money squandered in the past. The taxes paid are not compensated by any present service rendered by the government’s apparatus. The government pays interest on capital which has been consumed and no longer exists. The treasury is burdened with the unfortunate results of past policies.”

Therefore, if any ‘services’ are to be rendered by the government once its existing debt burden exceeds a certain threshold, it will have to spend ever more – and this can only be done by either raising taxes, borrowing more funds or by means of monetary inflation. In reality, all three have been and continue to be resorted to by modern-day governments.

We often hear that government debt is required by financial institutions to render the service of ‘safe collateral’, but this ‘safety’ is an illusion.

But deep down nobody truly believes that these debts will ever be paid – and if they are paid, then likely only with money the purchasing power of which has steeply diminished. Essentially, government debt everywhere is a  Ponzi scheme: old creditors are paid off with funds received by new creditors  and the scheme continues to expand in size, seemingly inexorably. Here is a chart showing the US Federal debt. Since the year 2000, the US government has issued almost twice as much additional debt as it has issued in its entire history from 1776 to 2000.

 US_federal_debt_2000_2013

US federal debt has nearly tripled since the year 2000

It is no coincidence that the true broad US money supply TMS-2 has risen by nearly 230% over the same time span. Here is a chart showing this monetary aggregate. Note the remarks we have added – if the growth rate in this monetary aggregate should slow down again, the Bernanke echo bubble will crash. The entire so-called ‘recovery’, such as it is, depends on this money supply inflation continuing at a steep rate:

US_TMS2_1988-2013

US money supply TMS-2 since 1988. Since the year 2000, the money supply has increased by nearly 230% – whenever the rate of increase merely slows down, asset markets and the economy tend to crash.

One conclusion from this is that the authorities are now ‘boxed in’. They have to continue to spend and inflate, otherwise the liquidation of malinvested capital the Fed has arrested with its money printing exercises will immediately resume. But can such a policy be continued forever and ever without any untoward consequences?

The answer to this question must be a resounding ‘no’. Already the US banking system has begun to sharply reduce the issuance of inflationary credit, which is a sign that the economy is structurally so severely damaged that there is literally ‘nothing left to lend’. In other words, if the banks were to issue additional credit from thin air – something they could in theory do – they would do so in the knowledge that this credit cannot ever be repaid, as  underlying economic activities are no longer able to support the addition of even more debt. In fact, it is to be questioned whether they can support the already existing outstanding debt. Too many credit bubbles have apparently consumed too much real capital. We may already be at the point of no return, where it is simply ‘game over’.

And yet, total credit market debt outstanding continues to grow, as the government has stepped in to an extent exceeding any private sector deleveraging that may have occurred. In fact, only part of the private sector is actually reducing its debt load, namely households. Corporations, just like the government, keep going ever deeper into debt (which is putting their record high aggregate cash hoards into perspective. Note that neither the cash held by corporations nor the debt on balance sheets are evenly distributed; the aggregation of such numbers obscures more than it reveals).

 credit_market_debt_owed_1970_2013

Total US credit market debt owed continues to zoom to new record highs after a one year pause following the 2008 crisis.

We strongly suspect that both government debt growth and money supply inflation will continue unabated – any pause will immediately bring about the kind of short term economic pain these policies have explicitly sought to prevent and will therefore be quickly reversed.

It is not unlike the situation the revolutionary assembly of France found itself in in the late 18th century: when it issued new money, industry seemed to revive. As soon as it stopped, industry slumped again. And so it was decided to issue ever more money, until the entire scheme blew up.

There can be little doubt that modern-day governments are on the road to a similar date with destiny – and lately the speed at which they travel toward it has increased markedly.

Implications for (physical) gold investors

The gold market has been under pressure ever since it has begun to lose its ‘euro crisis premium’. Nowadays nearly all the banks and brokers that turned bullish on gold when it rallied above $1,500 per ounce are fashionably bearish. Of course such analyses cannot help investors at all. Who needs an analyst who is turning bullish at $1,500 or 1,600 or 1,700 and then turns bearish at $1,400 or 1,300? Obviously one cannot make money with such advice.

However, these considerations are only relevant for traders. Longer term investors should not worry too much at what price gold trades from day to day or week to week. They buy gold because they must expect that government debt and monetary inflation will indeed continue on the path they have been on for quite some time now and that the above mentioned ‘date with destiny’ is very likely unavoidable.

Of course there is always a remote possibility that fiscal discipline and monetary policy rigor will make a comeback, but betting on such an outcome seems foolish. The incentives for politicians and bureaucrats are all firmly skewed in the opposite direction.

The current equanimity of markets and the enormous faith market participants apparently have in central banks and their ability to ‘keep things under control’ are likely to prove to be ephemeral phenomena. They are based on a comforting fantasy, as most people find other possibilities too ghastly to contemplate. That actually creates an opportunity to buy gold at a discount. On the day when this unbridled faith in central bankers crumbles, one will do well only if one already has one’s insurance in hand, preferably safely stored where it is well outside the grasp of the bureaucratic and political classes.

As noted above, there is always an outside chance that this insurance won’t be needed. The market economy, in spite of all the obstacles arrayed against it, continues to produce wealth. Not every investment is misguided, even though economic calculation is severely distorted by present-day policies. If the proper framework is put in place, the economy will thrive.

However, the chances that such insurance will indeed be needed seem greater today than ever. It matters little that Europe’s crisis no longer dominates the headlines; what one must ask is: has anything changed? Nothing has – the mountain of public debt in Europe continues to grow. Japan is engaged in an extremely dubious monetary and fiscal experiment even while the size of its public debt hastens from record to record. Everybody knows this is unsustainable – the only question is when the day will come when the markets finally throw a fit and the unsustainable nature of this situation becomes glaringly obvious to all. It is unknowable at this time which of the many possibilities will provide the next crisis trigger – but it should be clear that things cannot simply continue along current lines for all eternity.

The choice is to either trust in fallible politicians and bureaucrats or in gold – we certainly know what we prefer.

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