With all the hoopla about the US government shutdown and the upcoming debt ceiling drama, investors may be overlooking a simple, yet important report issued by the US Treasury at the end of September that sums up the latest fiscal year - the US Debt Position report for 2013. This is actually one of the most important data points for long-term gold investors because it goes into one of the most fundamental reasons why gold needs to be owned by investors.
Here's the latest US Treasury reported Debt and Activity Position:
Though this report is a summarized version of far more detailed reports on the US debt position, it does have a very interesting chart on the first page:
Investors should note that the 2013 debt total is not included in the above chart, but all one has to do is add another orange bar about $700 billion dollars higher and to the right of the 2012 total and continue the staircase.
Now, it's no secret that the US owes a lot of people a lot of money and many other countries owe creditors large amounts of money - so why is the US different?
The primary reason that the US is different is because the US Dollar is the world's reserve currency and its value is directly related to the sustainability of US debt - understanding the future direction of the Dollar requires an understanding of the US debt situation. Investors should remember that almost all past currency devaluations in modern times were because the debt load of a particular nation reached a point where the government could no longer support it without devaluing the currency (or defaulting on the debt - which also devalued the currency). Since there are no real reserve currency alternatives to the US Dollar besides gold, any decline in the reserve standing of the US Dollar would mean an increase in the reserve value of gold - which would mean an increase in the value of gold.
Since the sustainability of the US debt burden has a significant relationship with the future value of the US Dollar and its reserve currency standing, the less sustainable the debt is then the less value the US Dollar will have as a reserve currency - and thus the more value gold will hold as a reserve currency. In fact, we believe the primary driver of this current bull market in gold that started in 2001, was because there was a shift in the thinking of the future value of the US Dollar as the world's reserve currency. It is actually very interesting because in the chart above, US total debt started to really increase in the early 2000's - the beginning of the gold bull market. We do not believe this was a coincidence.
Investors should remember that in the early 2000's gold was rising even though there was no Quantitative Easing (QE), the stock market was rising, it was not a mainstream investment, central banks were not accumulating gold in large amounts, there was no financial crisis, gold mine production was similar to today's levels, and so on. Many of the reasons that financial pundits currently give for the end of the gold bull market were simply not even factors during its bull run, so how they would lead to gold's demise is beyond me.
We believe that the gold bull market's primary driver was (and is) the gradual realization by entities all over the world that their US Dollar holdings are not going to hold the value that they would thought they would hold. That's why we saw in the 2000's a gradual but steady rise in the price of gold, because all of these players, independently of each other, were steadily accumulating gold because they simply did the math on the future value of their dollar holdings and decided that they'd rather own gold.
Let us now take another look at US debt chart above from the Treasury report and investors can draw their own conclusions into its sustainability.
Source: US Treasury
As investors can see, US Debt has been rising steadily at an average of 8% per year and every year the nominal increases have been larger and larger.
Additionally, investors should note that the numbers for 2013 are a bit skewed because the US Treasury has been engaging in extraordinary, artificial measures since May to stay under the $16.7 trillion debt ceiling - the debt burden will probably jump as soon as the US Congress approves an increase in the US debt ceiling. So the slowdown in US debt growth is mostly due to artificial measures taken by the US Treasury to stay under the debt limit that will be unwound as soon as the debt ceiling is raised.
But the total outstanding debt doesn't tell the whole story because as everybody knows, debt is made lighter or heavier by the rates of interest on that debt.
Source: US Treasury
As investors can see above, not only has the total outstanding debt grown, but it has been growing even as interest rates have fallen significantly. In fact, the US is paying more in interest today than in 2000 when interest rates were 300% higher! So what happens when interest rates rise?
If interest rates double from current levels, it would still put them at the low levels of interest we witness in the mid-2000's and would lead to an increase in annual US interest payments of around $400 billion. If they rise to the 6% range that was prevalent in the 1990's and early 2000's, then the US Government would be paying approximately $800 billion more in interest than it does today, or over $1 trillion in interest payments!
To put that into perspective, Apple (AAPL) earned approximately $41 billion in FY2012, Exxon (XOM) $45 billion, Walmart (WMT) $17 billion, Microsoft $22 billion, and Google $11 billion. In fact, if the top 10 earners in the S&P 500 used all of their earnings to pay only the additional interest expense if US debt rose from current levels to 4.5% (where it was in 2006 and 2007) it would not be enough to cover it - and interest levels in those days were LOW compared to historical levels. What if interest rates rose to more normal levels? How many companies would need to pay that additional $800 billion of interest expenses? All of the earnings of the top 100 companies? The top 150 companies?
Regardless, it is a staggering amount of money that would need to be used simply to pay off the additional interest if rates rise to normal (pre-2007) levels. Let's not forget that we are talking about only servicing the debt not paying it down, and we are assuming that debt levels stay exactly where they are right now - not something that even the rosiest forecasts predict.
If that wasn't bad enough, all we've covered so far is the actual government debt, but what about those promises that the government has made via Medicare, Social Security, etc? None of those are included in the US national debt calculations and if one adds those up the debt balloons anywhere from $50 to $100 trillion dollars - which is obviously much more than can possibly be ever paid. For the sake of time we can't go into the details of the unfunded liabilities numbers, but Chris Cox and Bill Archer go over it in more detail in this Wall Street Journal article.
The conclusion of all of this should be pretty clear by now - the financial burden of the US is simply not tenable. By analyzing the numbers investors should see that simply paying off the interest (no principal) with organic growth would require such a large amount of dollars that it simply isn't feasible. The only real options are default (highly unlikely) and inflation - which would ease the debt burden at the expense of debt and US Dollar holders.
Historically this is nothing new, but since the US Dollar acts as the world's reserve currency, holders of these dollars are looking elsewhere for safety - which is where gold comes in. In fact, we believe this was the primary reason for gold's rise since the beginning of the last decade. Gold was rising long before QE, before the financial crisis, before the housing crisis, and before it became popular (and unpopular) - even rising in lock-step with the stock market. The primary reason to own gold was because the financial burden of the country issuing the world's reserve currency was becoming too great to bear and clear to players all over the world - gold is the only other real option as an alternative reserve currency.
For gold investors nothing has changed in regards to this reason to own gold. In fact, the financial burden of the US is worse than it was in 2007 and even last year.
That's why we believe that investors should continue to accumulate physical gold and the gold ETF's (GLD, PHYS, and CEF). Investors interested in leveraging this situation into higher potential profits may also consider buying gold miners such as Newmont (NEM), Goldcorp (GG), Randgold (GOLD), the Market Vectors Gold Miners ETF (GDX), or any of the other gold miners. Though we always caution investors that gold miners are not necessarily an investment in gold - make sure you do your research before you invest in the miners.
We will close with a quote from Kenneth Rogoff and Carmen Reinhart:
"Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence - especially in cases which large short-term debts need to be rolled over continuously - is the key factor that gives rise to this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to e merrily rolling along for an extended period, when bang! - confidence collapses, lenders disappear, and a crisis hits."
Gold therefore provides 'bang' insurance just in case 4,000 years of economic history turns out to be right.